ETF Insights.

WHY INVESTORS SHOULD AVOID COMPLEXITY

One of the biggest attractions of having a broadly passive investment strategy is the simplicity of it. You don’t have to speculate on particular sectors or regions or constantly monitor how your portfolio is performing. The long-term market return is more than adequate to meet the need of most investors, and by simply aiming to capture that return at very low cost, you’re giving yourself every chance of a successful outcome.

Index funds themselves are beautifully simple, and so too are passively managed exchange-traded funds, or ETFs. You know exactly what you’re getting with them. But when you buy an actively managed fund you’re next quite sure. Many active equity funds, for example, include an element of bonds, cash or both, and because active managers typically turn over their entire portfolio every couple of years or so, it’s very difficult to keep tabs on everything you own at any given time.

A more worrying development in recent years is that, with active managers finding it increasingly hard to beat their benchmarks, they are resorting more and more to complex strategies. Principally, these strategies come in three different forms:

Leverage — in other words, the fund manager borrows money to increase the potential return of an investment

Short selling — that is, the manager sells a security that they don’t own, or that they have borrowed, in the hope that the the security’s price will decline, allowing them to buy it back at a lower price to make a profit

Options -- in other words, the fund manager pays for the right to buy or sell a security at an agreed price at a later date

They’re often called hedging strategies; that is, they’re ostensibly designed to protect investors from risk. In practice, though, they often have the opposite effect;all three types of strategy carry a degree of risk that the end investor may not want to take.

Worryingly, recent research from Canada has confirmed that active managers are making increasing use of these complex strategies, resulting in higher fees, lower returns and greater risk. The paper in question, entitled Use of Leverage, Short Sales and Options by Mutual Funds, was produced by three academics at the Smith School of Business at Queen’s University in Ontario.

According to the authors — Paul Calluzzo, Fabio Moneta and Selim Topaloglu — in the 15 years prior to the paper’s publication in March 2017, 42.5% of US domestic stock funds have used leverage, short sales or options at least once. Between 1999 and 2015, the percentage of funds allowed to use all three rose from 25.7% to 62.6%.

But, the researchers found, there was a price to pay for end investors for this additional complexity. Funds that used complex investments, they calculated, had a 0.59% decrease in excess return and a 0.072% increase in expenses.

So, what did the researchers find specifically on risk? To quote the paper: "Although (managers) use the instruments in a manner that decreases the fund's systematic risk, they hold portfolios of riskier stocks that offset the insurance capabilities of the complex instruments.

“We find not only that funds that use complex instruments take more risk, both systematic and idiosyncratic, in their equity positions, but also that bylaws that authorise complex instrument use are associated with greater fund risk.”

In the paper’s conclusion the authors say this: “Our results suggest that the use of complex instruments is associated with outcomes that harm shareholders: lower returns, higher unsystematic risk, more negative skewness, greater kurtosis (essentially volatility) and higher fees.

“Overall, it appears that mutual fund investors are better off choosing simplicity.”

So, why is it that active managers are using these complex strategies more and more? The bottom line is that regulators have allowed them to. But you could also argue that one reason active managers are resorting to using them is that they’re increasingly under pressure to prove that they can beat the index. Put another way, active managers are becoming increasingly desperate.

To quote the investment author Larry Swedroe: “The active world has to fight back to keep their share, and one way to do that is to add complexity. They need to say, ‘We have a story to tell, and you need to be a member of our secret club, which has all theses superior instruments.’”

Investors should not be seduced by these sorts of marketing messages. In investing, simplicity is the ultimate sophistication, and ideally that means avoiding actively managed funds altogether.

Contingent Convertible Bonds or "CoCos" have both bonds and equity-like characteristics.

CoCos pay an attractive income with higher credit quality than traditional high yield bonds, and have additional diversification benefits

What are CoCos?Following the 2008 financial crisis, banks had difficulty issuing traditional debt securities, and had to sit on a large amount of capital to ensure their balance sheet strength was maintained.

CoCos were created as the issuing banks flexible friend. This is because are designed to absorb losses when the balance sheet of the issuing banks weakens below a threshold level.

Losses can be absorbed by the CoCo converting into equity or suffering a write-down of its principal value making it more flexible than traditional bank securities. To offset the risk of loss, CoCos are issued with a higher coupon than traditional bank bonds.

Accessing CoCosWhilst bond funds may include CoCos, direct access to CoCos as a targeted allocation was previously only available to institutions who could meet minimum issuance sizes from one or more issuer.

By accessing CoCos using an ETF, the minimum investment drops to $100, and the ETF is diversified across 29 CoCos from 24 different issuers.

Why include CoCos in a portfolio?Convertibility into the issuing bank’s shares means that CoCos provide an exposure that has both bond and equity-like characteristics. When there is higher risk of balance sheet stress, CoCo's behave more like equities. When there is lower risk of balance sheet stress, CoCo’s behave more like bonds.

CoCos' moderate correlation to equities and low correlation to Corporate and Government Bonds makes them a useful diversifier from a portfolio construction perspective.

Fig.1. Correlations to major asset classes

Bigger income & better credit qualityCoCos have an attractive income to reward risk taken, but a better quality credit rating compared to traditional High Yield Bonds.

Fig.2. Income Profile

Fig.3. Credit Profile

Furthermore, in terms of counterparty risk, CoCos are only issued by large banks that are well regulated with high capital ratios.

How about performance?CoCos have outperformed EUR bonds and equities, both excluding and including Financials exposure.

​Fig.4. Total Returns

CoCos are positioned between equities and bonds in respect of realised volatility, but with better risk-adjusted returns.

Fig.5. Risk-Return​​

In summary, CoCos have offered solid risk-adjusted returns (Sharpe Ratio), and have a low correlation to bonds from a diversification perspective and a higher income with better credit quality relative to traditional high yield bonds.

The Capital Allocation Line is the line that links the risk-free asset with the market portfolio.

We use index/ETF proxies for these asset classes for GBP-based investors.

We chart recent historic and medium/long-term expected risk/returns for these asset classes to get a snapshot of where markets positioning at 1q18.

CAPM 1Q18 SNAPSHOT (GBP)The Capital Allocation Line is the line that links the risk-free asset with the market portfolio.For GBP-based investors, we use UK Government Bonds as a proxy for the risk-free asset, and UK Equities as a proxy for the market portfolio.

For 5 year, and Long-term, expected risk/return of these asset classes we use estimates from BlackRock Investment Institute.

As expected, the CAL is upwards sloping: the higher the expected risk, the higher the expected return.

For comparison, we superimpose on to those estimates, a snapshot of the historic 1 year and 3 year actual risk/return of these asset classes based on the performance of their respective ETFs.

Following our initiation of overage of the UK Equity Income Index/ETF universe (data to 4q17), we have updated the data for 1q18 performance update for selected indices.

​ReturnsFor 1q18, the most defensive UK Equity Income index was the MSCI UK Select Quality Yield, tracked by ZILK, at -5.49% compared to -7.21% for the FTSE 100.On a 1Y basis, 90%xFTSE 100 returned +0.2% tracked by ZWUK, followed by -0.24% MSCI UK Select Quality Yield tracked by ZILK has performed best.On a 3Y basis our proxy benchmark for ZWUK, which takes 90%xFTSE100, returned +15.4%,, followed by +11.4% for FTSE 350 ex Inv Trust Qual/Vol/Yield Factor 5% Capped tracked by DOSH.

Risk AdjustedOn a 3Y basis, 90%xFTSE 100 as a proxy for the benchmark tracked by ZWUK, followed by FTSE 350 ex Inv Trust Qual/Vol/Yield Factor 5% Capped tracked by DOSH, have delivered best risk-adjusted returns.

Compared to 4q17, the index's biggest switches as at 1q18 have been from European High Yield Bonds and UK Equity to European Aggregate Bonds and Gold.

Risk-based indices are different to factor-based indices, as they focus on the interaction between securities, not the characteristics within securities. Put simply, it's an alternative, systematic approach to asset allocation and risk management.

We have published the quarterly index factsheet for the Elston Strategic Beta Global Minimum Volatility Index: a multi-asset risk-based strategy. The index strategy is designed to allocate to a diverse range of asset classes so as to minimise the volatility of the overall strategy.

UK regulator forced a number of asset management firms to pay £34m compensation to customers for “closet indexing”

Closet indexing means funds are presented as higher cost active, but actually just hug their benchmarks

We estimate there is €0.4 to €1tr of assets in “closet index” funds in Europe, depending on what criteria are applied. Either way, fund houses have been warned

“Mutton dressed as lamb” is a derogatory old saying of something or someone that’s dressed up to look better than it is. In olden days, some dodgy butchers would dress mutton up to look like lamb to get a higher price. I’ve got nothing against mutton. It offers good value for money and does a nutritious job. But I don’t want to be given one thing when sold another.Some “active” funds that actually hug an index is another form of misrepresentation. And this month, the UK regulator got tough forcing a number of fund houses to pay £34m compensation to customers overcharged in closet index funds.As this is the first closet indexing fine of its kind internationally, it’s worth taking a closer look.

What happened?The furore is around “closet indexing” where mutual funds charge active fees to deliver an investment style that pretty much tracks the index which it aims to outperform. When marketed as active, this is misrepresentation. Furthermore, closet index funds offer poor value for money compared to genuine index-tracking fund or ETFs for the same given exposure.

What exactly is closet indexing?“Closet indexing” is a term first coined – in public at least – by academics Cremers & Petajisto in 2009. The study and metrics around “active share” and “closet indexing” caused a stir in the financial pages on both sides of the Atlantic as active managers started to watch the relentless rise of ETFs and other index-tracking products.

In March, the UK regulator struck after sampling funds from 19 UK asset management firms. Of the 84 suspected closet index funds reviewed, the FCA required changes to the descriptions of 60 funds to ensure they were not misleading. Furthermore, an undisclosed number of unnamed firms managing an undisclosed number of funds were required to compensate their customers £34m: not for providing index-like returns, but for saying one thing and doing another.To be clear, the issue around closet index funds is not simply about fees. It’s as much about transparency and customer expectations.

How can you define “closet indexing”?There has been some speculation as to what methodology the FCA used to deem funds a closet indexer. In this respect, ESMA’s 2016 paper may be informative. Their study applied a screen to focus on funds with 1) AUM over EUR50m, 2) an inception date prior to January 2005, 3) Fees of 0.65% or more, and 4) were not marketed as index funds. Having created this screen, ESMA ran three metrics to test for a fund’s proximity to an index: active share, tracking error and R-Squared.

The Closet Index Metrics in summaryActive share shows the percentage of the portfolio that does not coincide with index.Tracking Error shows volatility of difference in return fund and index.R-Squared represents the percentage of fund performance explained by index performance – a correlation measure.

On this basis, a fund with low active share, low tracking error and high R-Squared means it is very similar to index-tracking fund. But what are the thresholds for each metric and how many funds are caught in the net?

A trillion euro problem?ESMA sets out three thresholds – each increasingly stringent – by which closet indexing could be defined. These are set out in the table below:

Based on Morningstar data we estimate the European funds industry to be approximately €8tr in 2016, implying on our estimates €1.2tr could be defined (at its loosest definition) as closet indexing, with €400bn (at its tightest definition) coming under particular scrutiny.

Where next for fund houses?Fund houses in the UK and Europe have some thinking to do. Are they offering building block components, or managing solutions? Our view remains that those offering solutions will prosper, whilst those offering building blocks risk commoditisation.

Price pressure from index funds and ETFs has been present for a while, but so far traditional brands and distribution networks have proven resilient. But with the regulator now joining in to target closet indexers, the “big switch” for core exposures from actively managed funds to index-tracking funds is likely to accelerate, in our view.

Embracing changeRather than embracing change, European asset managers that don’t currently offer ETFs have so far been hesitant to launch. They should get over it. Fund houses have embraced different fund wrappers which have over time: investment trusts (one of the earliest just celebrated its 150th anniversary), unit trusts, OEICs, SICAVs, ICVCs to name a few. ETFs are just a not-so-new tradable way of delivering a basket of securities to the investor. Technology changes. Purpose does not.

So European asset managers should launch, not fear, ETFs. Or watch their American cousins eat an ever cheaper lunch.

A winning formulaTomorrow’s winners in the European asset management space, in our view, are those firms that are:1) close to asset owners;2) can offer solutions as well as components; and3) are part of the low-cost revolution, not victims of it.Fund houses that meet all three of these tests are in good shape. There are some big British behemoths that don’t yet meet those tests. Unless they act, they risk getting left behind.

Indexing and proudIndex investing is transforming the UK retail investment landscape. It is creating a Moore’s Law for the fund manufacturing. It’s time to get involved.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article has been written for a UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange); “LON:” (London Stock Exchange). For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information and disclaimers, please see www.elstonconsulting.co.uk Photo credit: as per specified source; Chart credit: as per specified source; Table credit: as per specified source. All product names, logos, and brands are property of their respective owners. All company, product and service names used in this website are for identification purposes only. Use of these names, logos, and brands does not imply endorsement.

A well flagged correctionThere was near consensus amongst investment managers in their 2018 outlook as regards the risk of a market correction. Equity markets had climbed relentlessly higher in 2017 with little red ink and eerily low volatility.

The fact that equity volatility had converged with bond volatility illustrates the limitations of an asset-based approach to diversified multi-asset investing.

Of course, it was not to last. It was a question of “when, not if” equity volatility mean reverted. And now we at least know when “when” was.

Fig.1 VIX spikes as equity volatility comes back into play.

Source: Bloomberg.com

What was the trigger?A potential trigger was identified as above-expected inflation trends, leading to increased expectations of monetary tightening. And so it was.

If fully invested, stay invested. Focus on fundamentals, not technical. Broad based economic expansion is still on track, and valuations are still ok relative to slightly-higher-but-still-low bond yields.

If sitting on cash reserves, consider an entry point if you believe there’s still room to run for the economy and markets

What is risk-based diversification?In periods of market stress (when the VIX index spikes), correlations between asset classes tend to increase in the short-run, thereby reducing the diversifying power of a traditional asset-based approach.

A risk-based approach means that allocations to asset classes are not driven by their label but to their realised risk, return and correlation characteristics. This means that genuine diversification can be delivered using a mathematical risk-based approach, rather than relying on labels alone.

References:http://www.spindices.com/indices/strategy/sp-500-managed-risk-indexhttps://www.deltashares.com/products/sp-500/overview/http://www.elstonconsulting.co.uk/factsheets.htmlhttps://www.bloomberg.com/news/articles/2018-02-02/u-s-added-200-000-jobs-in-january-wages-rise-most-since-2009[ENDS]Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.Business relationship disclosure: The Elston Minimum Volatility Index is licensed to Commerzbank for the creation of investable certificates (professional investors only).Additional disclosure: This article has been written for a US and UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information and disclaimers, please see www.elstonconsulting.co.uk Photo credit: as per specified source; Chart credit: as per specified source; Table credit: as per specified source. All product names, logos, and brands are property of their respective owners. All company, product and service names used in this website are for identification purposes only.

In the search for yield, UK Equity Income is a key component of client portfolios.

There are a number of London-listed UK Equity Income ETFs to choose from, each tracking a different index methodology.

This report looks at the best performing UK Equity Income indices in absolute and risk-adjusted terms for GBP investors.

UK Equity Income IndicesInvestors have a choice of UK Equity Income index strategies, each with different risk-return characteristics, weightings methodologies and factor tilts.These difference influence the performance of each index strategy (all figures below are on a total return basis for GBP investors).

Best performing for 2017The best performing strategies for UK Equity Income in 2017 were:

ConclusionDifferent index construction methodologies has a material impact on performance outcomes – both in absolute terms and on a risk-adjusted basis.

A naïve interpretation is to consider performance in isolation, however our view is that index selection is more nuanced than that: it should relate to the objectives and constraints of individual client portfolios and the desired exposure - on asset-basis, risk-basis and factor-basis and the interaction between the selected strategy and the rest of a client portfolio.

Note: Scope of our comparisonFor these reports, we have analysed the indices and ETFs detailed in Fig.3.

[ENDS]NOTICES: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it.This article has been written for a US and UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information and disclaimers, please see www.elstonconsulting.co.ukPhoto credit: N/A; Chart credit: Elston Consulting; Table credit: Elston ConsultingAll product names, logos, and brands are property of their respective owners. All company, product and service names used in this website are for identification purposes only. Use of these names, logos, and brands does not imply endorsement.Chart data is as at 30-Dec-17

Focus on market cap indices is a choice, not an obligationA market cap weighted approach has well known drawbacks: it biases larger companies, regardless of efficiency and is "procyclical" - buying larger amounts of more expensively valued companies.

This is a critique of "passive investing". We don't believe there's such a thing as passive investing. There is index investing and non-index investing. There is subjective investing and systematic investing. Choice of index, choice of methodology, choice of asset allocation are all active decisions. Index investing simply delivers the desired investment approach in a way that is efficient, transparent and cheap.

Factor-based indicesThe arrival of factor-based indices, means that for a required World Equity exposure, we can select which factors we want exposure to: for example, Size, Momentum, Quality, Value or Minimum Volatility.

How have these different factors fared?Ranking the 1Y performance of these factors in 2017: Momentum factor delivered the highest total return at +20.6%, followed by Size factor at +13.1%, followed by Quality factor at +12.5%, followed by Value factor at +11.5%, and finally Min Volatility at +7.1%. This compares to +13.2% for the traditional cap-weighted approach.

Fig 1. Equity Factor 1Y Realised Risk-Return

On a 3Y basis, the annualised returns of Momentum come in at +18.2%, followed by Size at +15.7%, followed by Quality at +15.2%. This compares to +14.6% for the traditional cap-weighted approach.

Fig 2. Equity Factor 3Y Realised Risk-Return

Risk-Adjusted ReturnsRanking the 1Y risk adjusted performance by Sharpe Ratio: Momentum leads at 1.94, followed by Size at 1.44, followed by Quality at 1.30. This compares to 1.37 for the traditional cap-weighted approach.

On a 3Y basis, Size leads at 1.33, followed by Momentum at 1.30, followed by Quality at 1.19. This compares to 1.15 for the traditional cap-weighted approach.

In Fig 3. we plot the 1Y and 3Y Sharpe ratio for each World Equity factor relative to traditional cap-weighted Global and EM Equity indices, to compare the risk-adjusted returns of different factor exposures over different time frames.

Fig 3. Equity Factor Sharpe Ratios

Conclusion: a differentiated approachWe are not suggesting that one factor approach is inherently superior to another. But with a broader array of factor exposures readily accessible to decision-makers to match with their portfolio requirements, there's no longer need to complain about the limitations of cap-weighted indices.

NOTICES: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it.This article has been written for a US and UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information and disclaimers, please see www.elstonconsulting.co.ukPhoto credit: N/A; Chart credit: Elston Consulting; Table credit: Elston ConsultingAll product names, logos, and brands are property of their respective owners. All company, product and service names used in this website are for identification purposes only. Use of these names, logos, and brands does not imply endorsement.Chart data is as at 30-Dec-17